ANALYSIS-Regulation will wreak havoc on shadowy NDFs

SINGAPORE, June 7 (Reuters) - It has been the dark side ofcurrency markets: a secretive multi-billion dollar world ofsimulated contracts that skirts around government controls andrules.

Now regulators are about to force this global market innon-deliverable forwards (NDFs) out of the shadows with rules ontrading and central clearing that brokers fear will cause themarket -- and their industry -- to shrivel.

Almost every financial centre from Hong Kong to New York isset for new rules which will force trades in NDFs to go througha central clearing house, and data on these transactions to bereported.

The U.S. Dodd-Frank legislation goes further and requiresderivatives to be traded electronically, and bans banks fromproprietary trading in any product, including NDFs.

The American reforms include other rules on engagement, themost draconian being on the mandatory number of quotes that aparticipant should solicit for every trade and a requirementthat pre-arranged orders be flashed on screens for 15 seconds.

That's anathema for a market which was born out of a need tobypass regulation and is now used on a global scale by thebiggest banks, businesses and fund managers to hedge exposuresto emerging market currencies such as the Chinese yuan andBrazil's real.

It's not just the scrutiny of NDFs that's a worry for banktreasurers. Dealers and brokers fear there will be a decline inliquidity and profitability, loss of anonymity and the risk ofbeing undercut by rivals.

"It's a business killer," said one source at a leading bankin Singapore, who declined to be named owing to the sensitivityof the matter.

Unmonitored and undisclosed, no one's quite sure what kindof NDF volumes and trades go through now. Brokers can only guessthat the NDF market in the Chinese yuan is now the largest, withvolumes of $4 billion to $6 billion traded each day. NDF marketsin the Korean won and Indian rupee are almost as large.

Among the most non-interventionist and pliant ofderivatives, even the most benign of the rules spells revolutionfor the NDF market.

CLANDESTINE PLAYGROUND

The U.S. plan to move bilateral, non-standardisedderivatives, mainly interest rate swaps and NDFs, ontoelectronic trading and central clearing platforms has been setin motion, but their final reach and impact is unclear.

That is partly because Singapore's central bank and otherregulators in Asia, home to the biggest NDF markets, have so faronly proposed rules on central clearing and trade reporting, noton electronic trading.

Non-deliverable forwards were born in the early 1990s as away to beat capital controls in emerging markets, with the firstmarkets being in the Taiwan dollar and Mexican peso. Thecontracts were in dollars, and there was no need to hold theunderlying currency.

Initially created to help foreigners trade or hedge acurrency whose domestic markets were inaccessible to them, NDFshave become the clandestine playground for speculators and aboon for brokers, who could tailor deals for specific sizes andtimings, even split settlement dates.

The rise of electronic platforms infused transparency andefficiency in spot trades for major currencies, but killed theinterbank bilateral trade, putting plenty of bankers andvoice-brokers out of work.

The worry for brokers now is that Dodd-Frank and rules fromother regulators on clearing will cut the market down to size.Ben Feuer, head of foreign exchange for Asia at broker Newedge,says there is no doubt the NDF market will shrink and someproducts may even disappear.

"The larger institutions will be able to conform to the newregulations and associated costs incurred. However, smallermarket players can be squeezed out of the market, directlyaffecting the volumes," Feuer said.

The U.S. proposals for forced electronic trading and theneed to substantiate other risk-management activities or clienttrades will radically reshape a market that has been for longaccustomed to bilaterally and flexibly negotiating speculativebets on the likes of the Korean won and Chilean peso, away fromthe prying eyes of authorities and peers.

"NDF traders will resist using the machine," said oneSingapore-based broker. "When you use the machine, you lose thespread and volatility. It's going to kill employment, that's forsure."

WILL RULES CROSS BORDERS?

The timeline for implementing the rules remains fuzzy, giventhere is uncertainty over how different jurisdictions willinterpret them, although the Group of 20 (G20) leading economieswants them to be in place by the end of 2012.

In the United States, the regulation on swap trading andformer Federal Reserve chairman Paul Volcker's rule on whatbanks can and can't trade reaches deeper into every aspect ofthe derivatives market.